In this article, I will cover my thoughts on the following topics:

1. What is value investing?
2. What is intrinsic value?
3. What are some common accounting metrics to identify value stocks?
4. What is some of the criticism of value investment strategy?
5. Buffet-notion of value investing
6. My take on value investing as an applied value investor.

Value Investing

Let us begin with a quote from Benjamin Graham, considered by many to be the father of value investing.

“We know from experience that eventually the market catches up with value. It realises it in one way or another”, –Benjamin Graham, 1955

This quote captures the essence of value investing.  Essentially, value investing is a framework for investing in equity assets that are trading at a significant discount to their intrinsic (or inherent) value. The idea is that the purchase of stock-asset below intrinsic value offers a margin-of-safety that can help absorb undesirable developments resulting from market overreactions on the downside.

It is clear from above definition that intrinsic value is at the heart of value investing strategy.  So what is “intrinsic” value of a stock?

Intrinsic Value

Philosophically speaking, value is something that exists in the mind. To define value is therefore as difficult as defining life itself. Even Benjamin Graham eschewed from precisely defining value for a given stock. However he did offer some guiding principles to assign a value, which he refered to as intrinsic value, to stocks.

Intrinsic value can be thought of as the dollar amount per-share that one can assign to a stock based on future earnings and dividends, discounted to today.

While theoretically sound, in practice the above definition leaves quite a room for guess work. For no one knows the future, let alone determining whether the company will survive. Intrinsic value is therefore at best an estimate for value, in terms of dollars, of the firm and can never be measured precisely.

One can though under assumptions, mathematically formulate the notion of future earnings discounted to today and obtain an estimate for intrinsic value of stock.

There are basically three approaches, commonly found in literature, on estimating intrinsic value for a stock:

1. Discounted Cash Flow (DCF) Model:  Use firms discounted future cash flow to compute intrinsic value
2. Dividend Discount (DDM) Model: Use firms discounted dividend cash flow to determine intrinsic value
3.  Price-Earnings (PE) multiple: Use discounted future earnings per share to determine the intrinsic value

Detailed discussion on these methods is a topic for the future. For now, it suffices to know that whatever method is used to estimate intrinsic value, it involves knowing the future and since future is unknow, it involves making a guess.

To further hammer upon the above point, in the table below , I list the intrinsic value for Apple, pulled together from several sources:

Unsurprisingly enough, there is a quite a wide-range in the estimates for intrinsic value.

Accounting metrics for Value Investor

For a value investor, pulling the trigger on purchase of an equity asset is much easier if the following two conditions are met:

1. His/her estimate for intrinsic value for stock asset is above the current market price for the stock and
2. There is a significant margin of safety underlying the price paid for aquiring the asset.

While there are several financial metrics that can be useful in stock valulation, see here for example,  below, I list 3 financial metrics that I have found useful in in assessing the margin-of-safety aspect of an investible asset:

1. Earnings Yield (EY): EY as a accounting metric for margin-of-safety was proposed by Benjamin Graham in his book, The Intelligent Investor. EY is calculated as inverse of Price-Earnings (PE) ratio, by dividing the earnings per share (EPS) to the current market price for the share. The higher the difference between EY for a stock and the 10-year treasury yield, higher is the potential margin-of-safety for the stock.
2. Price to Sales Ratio (PSR): PSR as a metric to value stock was first proposed by Ken Fisher. As opposed to PE ratio, PSR uses corporate sales to value a company. It is calculated by dividing company’s market cap by the total revenue in the most recent year.  PSR can be a good metric for identifying growth stocks that have taken a hit in earnings due to a short-term hiccup. In general, lower the PSR, higher the margin-of-safety.
3. Payout-Ratio (PR): For firms that pay dividend, PR can be a critical measure to define margin-of-safety. PR is calculated as the ratio of firms dividend per share (DPS) to earnings per share (EPS). PY>100% indicates that the firm is paying its share-holders more money than it can earn… Clearly such a trend cannot last forever. Lower the PY, higher the margin-of-safety that the dividend income stream will remain intact even in downturn markets.

Critique of Value Investing

Academic Finance is dominated by the Efficient-Market Hypothesis (EMH), first proposed by Eugene Fama. The basis idea is that market price of stock is the best price for stock, reflecting all the available information about the stock at any given moment in time.

Proponents of EMH claim that it is difficult to identify good stock trading at a bargain. Value investors seeking bargains will therefore end up with collection of “low” quality stocks with low market-to-book ratio relative to their growth peers.

Over long term, value investors tend to make money simply because they are willing to take higher risk on such low quality stocks and are rewarded in proportion to the risk they entail.

These ideas were formally captured by Eugene Fama and Kenneth French in one of their highly cited works titled, Common risk factors in returns of stocks and bonds.  This work led to the idea of value premium, defined as the risk adjusted returns of value stocks over growth stocks.

Buffet notion of Value Investing

It can be argued that the fundamental approach to value investing as proposed by Benjamin Graham, is to hunt for value premium, i.e., seek out bargain low market-to-book stocks.

Warren Buffet and Charlie Munger’s modified the basic value investing approach by their willingness to seek out high quality stocks not necessarily trading at bargain price, but available at fair price.

A recent article by David Harper on Investopedia titled, Warren Buffett’s Investing Style Reviewed, aptly summarizes Buffets approach to value investing and is worth a read for folks who want to understand why and how Buffet differs from the traditional Graham notion of value investing.

My take as an Applied Value Investor

I have adopted value investing principles to suit my needs for sustained wealth creation as an individual investor under the following constraints:

1. limited supply of time and resources
2. limited supply of capital and
3. average investor intelligence.

Fundamentally, I believe that markets from the perspective of an individual investor are extremely efficient and it is prudent to participate in the markets passively, by owning a basket of well-diversified index-funds that track the overall markets across all asset types.

At the same time riches cannot be had by simply following the markets, but rather seeking out opportunities to invest in high quality stocks, with high margin of safety, that may be trading at fair value and at times even at a siginificant discount to intrinsic value.

Accordingly, my approach is to allocate ~20 % of my investible assets for active value investing in the hopes of seeking alpha, while the bulk of my investible assets, are invested in a diversified portfolio of index funds.

As this blog evolves, I will dig deeper into specifics of my approach to value investing and portfolio diversification. I will use this forum to track my performance, my mistakes and lessons learned.

I am hopeful that this blog is useful to the commuity of individual investors, who like myself ,are on a self directed journey towards financial independence and share my passion for disseminating the education and experience gained over time for greater good.